University of Otago's Andrew Coleman looks at the intergenerational effects of the tax system on New Zealand’s housing markets

The following article is the seventh chapter from Progressive thinking, ten perspectives on housing, a Public Service Association (PSA) publication. Interest.co.nz is publishing all 10 chapters from different authors on various aspects of housing.

By Andrew Coleman*

The tax system plays a crucial role in New Zealand’s housing markets. At the simplest level, the Goods and Services Tax is applied to new land development and new house construction, raising the price of new housing by 15%.

But the effects of the tax system are more complicated than this.

Since 1986 several tax changes have caused an intergenerational rift in New Zealand society by increasing the prices young people pay to purchase houses.

Some of these tax changes appear justifiable on efficiency grounds, but even these have made it more expensive for young people to purchase or rent property.

In conjunction with other tax changes that have artificially raised property prices, a generation of older property owners have become rich at the expense of current and future generations of New Zealanders.

The scale of the problem

The scale of the problem is seen by observing how average property prices have increased by over 220% in inflation-adjusted terms since 1989; the highest rate of increase in the developed world.¹

The average size of new houses has also increased more quickly than in Australia or the United States, the only two countries that publish this data.

The average size of a new dwelling in 2013 was 198 m2, up from 125 m2 in 1989, and nearly twice as large as the average new house in Europe.

The tax changes that have affected housing can be divided into those that affect the cost of supplying housing and those that affect the demand for housing.

Unfortunately, unravelling the effect of taxes on house prices and rents is challenging.

The effects depend on the extent that the supply of new housing is responsive to prices.

If the supply of housing is very responsive to prices, taxes that affect supply prices (such as GST) become fully reflected in prices, while taxes that affect demand (such as the relative size of taxes on housing income and other assets) do not. Conversely, if the supply of housing is not really responsive to prices, supply taxes like GST have little effect on prices but demand taxes have large effects.

The analysis is further complicated because the supply of land – particularly land in good locations – is less responsive to price than the supply of new houses.

It is quite possible that a particular tax can simultaneously lead to higher land prices but not much new land, and larger houses but not much of an increase in building costs.

Since 1989, the ways that the tax system affects the demand for housing has been the biggest problem.

The fundamental difficulty is that the returns from other classes of assets such as interest income are more heavily taxed than the returns from housing.

Because interest is more heavily taxed than the returns from owneroccupied housing – which are essentially the rent people get from their own home – people have an incentive to live in larger houses than otherwise, and pay more for well-located properties.

In the absence of this tax distortion, many people would choose to live in smaller houses and land prices in major cities would be a lot lower.

It is not unreasonable to suspect the premium people pay for well-located properties is twice as high as they would pay under a non-distortionary tax system.

Incentives

But this is not all. The tax system provides incentives for landlords to pay a much higher price/rent multiple for the houses they lease, largely because the absence of a capital gains tax.

Because the houseprice/ rent multiple could increase either because house prices increase or because rents decline (or some combination of both), the tax system could make buying more expensive or it could make renting more affordable. Most of the evidence suggests house prices have increased rather than rents have fallen; either way, the result is a tax-induced decline in home ownership rates.

When the tax system causes artificially high house prices, costs are imposed on current and future generations of young people, who have to borrow more and pay higher mortgage costs.

Why 1989? New Zealanders have never paid tax on the capital gains associated with house price increases, and the way housing is taxed was not fundamentally changed in 1989.

This is true. But the distortionary effects of taxation depend on the way houses are taxed relative to other asset classes, and in 1989 the government changed the way some other capital income is taxed.

Until 1989, money placed into retirement saving schemes was tax deductible, and the earnings from this money were not taxed as they accumulated.

Under this tax scheme – which is used in most developed countries including the United Kingdom, the United States, France, Germany, and Japan – the money placed in these savings schemes is taxed in a similar way to housing.

It reduces the incentive for owner-occupiers and landlords to overinvest in housing.

While the distortions in the current tax system could be eliminated by introducing a capital gains tax on housing and all other assets, and by taxing the rent you implicitly pay yourself when you own your home, most countries have found this too difficult to do.

As they have discovered, it is far simpler to change the way other savings are taxed.

On the supply side, in addition to GST, the Local Government Act (2002) has also affected the cost of supplying housing by changing taxes.

Instead of levying property taxes (rates) to fund the costs of developing new sections, local governments have progressively imposed development charges.

This change has improved efficiency by moving the costs of a larger city to the new people populating it, but it has also increased the price of housing right across cities.

People who bought before 2002 shifted the cost of new development to others, increasing the value of their houses, even though their development costs had been paid by other ratepayers.

For a long time, economists have pointed out that if you tax the income from housing less than other assets, you tend to increase land prices.

At the macroeconomic level, they have noted that this tends to increase national debt levels, and lower national income.²

The first owners of land benefit from these schemes, but everyone else loses.

Perhaps this is a reason why other countries have been concerned to tax housing on a similar basis to other assets.

It is unfortunate New Zealand does not do so, even if the tax changes implemented since the late 1980s have proved very advantageous to middle-aged and older generations.

¹Data on house prices is from the International House Price Database provided by the Federal Reserve Bank of Dallas. See Mack, A., and Martínez-García, E. (2011) “A Cross- Country Quarterly Database of Real House Prices: A Methodological Note.” Globalization and Monetary Policy Institute Working Paper no. 99 (Federal Reserve Bank of Dallas, December).

²Feldstein, M. (1977) “The surprising incidence of a tax on pure rent: a new answer to an old question.” Journal of Political Economy 85(2) 349 – 360.

*Dr Andrew Coleman has half-time positions at the University of Otago, where he teaches economics, and at the Productivity Commission. From 2008 – 2016 he researched the interactions between taxes, housing markets, and retirement schemes at Motu Economic and Public Policy Research and the New Zealand Treasury, and in 2011 he was a member of the Saving Working Group.

Note: The views expressed in Progressive thinking, ten perspectives on housing belong to the authors and do not necessarily represent the view of PSA members or the organisation.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

• don’t allow foreigners to buy existing homes
• give tax breaks to property developers, we need the buggers to build and build first homes quick
• last of all completely overhaul the Resource Management Act. It is a joke and it is a deadweight on the supply of property

Rent controls will fail, the 1972 Labour Governement tried it which immense failure as most renters changed tenancies yearly and it cost a fortune to administer.

They can try and tax investors, but this won’t change things much as per Australia, UK, Canada, etc who are taxed heavily on investment property and all tax has done is disincentivise people from selling which depletes supply and puts prices up. First home buyers should also be realistic as too many of them want to start where Mum and Dad ended up, it’s delusional. However in Auckland (not the rest of NZ) the market has become dysfunctional.

Also forget the 3 to 1 income ratio of what house prices are supposed to be. This has changed over the years due to divorce rates being 50%, people not wanting to get married and in most cases we now have a working Dad and Mum in a household. So therefore the ratio should be based on a double income.

Last of all there is no evidence that property investment is taxed less than other assets. The author of this article needs to provide facts. Grant Robertson agreed last month at a Capital Property Investor meeting that property investment has NO tax benefits over any other business entity.

The logistics of this changed when women started getting into careers, far more so than the 1980s. It's not uncommon in Wellington for 2 people to live together and earn 160k plus combined (80k is the average Wellington city wage). Hence 600k for a home is realistic.

By the 1980s' ( and the 70's as well actually!) two income households were the norm. It's not a new development. The major difference is that pre-1980 most households were married ( no DBP or Single mother's Benefits etc) and marriage was The Norm. That may have changed. But the underlying income capacity of households? Hardly at all! 1970's may have had The Man's income used in calculations at the bank, but the wife was likely working as well. By 1985 - almost certainly.

What exactly does inflation adjusted mean? I ask because I think it a bit meaningless. Although I think the sentiment of the article is okay, it misses the credit aspect of a credit fueled asset bubble. You change the tax advantages, the bubble just appears somewhere else.

What is the 'Inflation-Adjusted Return'
The inflation-adjusted return is the measure of return that takes into account the time period's inflation rate. Inflation-adjusted return reveals the return on an investment after removing the effects of inflation. Removing the effects of inflation from the return of an investment allows the investor to see the true earning potential of the security without external economic forces.

How may kiwis of tax paying age in Queensland not, last reported at approx 500,000. Perhaps the strategy is to just keep driving educated youth to overseas locations, to pay tax elsewhere. Great return on tax payer education dollars there, but as long as the property prices can be kept high who cares....

That is incorrect. A lot of kiwis are coming home particularly from Australia as it's a dog's breakfast economically. There will always be people living there from NZ, particularly retirees. This happens in Europe too as elderly people flock to warmer climates like Spain to prolong life.

More Kiwis are coming home now, but there's still a net outflow of them. Hell, there's more than 500,000 in Australia alone. As soon as the Aus economy picks up and/or NZ goes into a recession the amount of Kiwis leaving will start to rise.

It seems pretty bizarre to attribute ALL off the dynamic of house prices to tax settings ( not to say those are irrelevant).. The elephant in the room is the sustained historically low interest rates. RMA is also a significant influence without any doubt.

I am not saying that it does not - the point is it is one factor among many and not the principal one at that.
Whatever you think of the size of the Panda ( and I do not think it is that large ) the relative attractiveness of NZ as an investment destination is clearly affected by :
- loose monetary policy , in China and worldwide.
- economic growth and capital formation in China
- capital export regime
.( .. long list continues .. peculiarities of NZ tax regime are on on it somewhere - but not near the top _.

For instance land supply is very high in Auckland, there is currently about 40-60% more land planned for development region wide than historic norms would require. Macroeconomic incentives for us having a huge oversupply of houses are working just fine.

Unfortunately the Auckland Council are world leadingly incompetent and gob-smackingly inefficient. In a region crying out for more housing in Auckland, they cut off land supply there whilst opening up vast areas around Wellsford.

Re: "Because interest is more heavily taxed than the returns from owneroccupied housing – which are essentially the rent people get from their own home – people have an incentive to live in larger houses than otherwise, and pay more for well-located properties.

In the absence of this tax distortion, many people would choose to live in smaller houses and land prices in major cities would be a lot lower."

This only holds for people who are mortgage free (which presumably is a fairly small proportion of people). People with a mortgage generally would be best to pay any excess income off their mortgage rather than put it in a term deposit so would not be paying any tax on the benefit they gain (i.e. avoided interest).

= no tax distortion or incentive to purchase a larger house that they would otherwise choose.

Clearly there is a tax incentive in owning rather than renting and investing. The author claimed there is a tax incentive to build a larger home than you want or need . That is only the case if you are mortgage free. If you have a mortgage then you could pay down the mortgage rather than add an unneceesary fourth bedroom and you would be much better off.

Actually, maybe I'm wrong on that. The author didn't specifically say there is an incentive to build a larger home than they want or need. So long as there is some benefit in having a larger house then yes there is a tax incentive to go after that rather than sacrifice some living conditions to invest.

Comes back to the TOP parties proposal to tax the imputed rent on the family home really doesn't it.

It really depends on what investment you choose risk wise. Deposits are boring and have no cap growth because they offer certainty unlike other investments. Similar to betting on a sports team paying $1.05 compared with a team paying $20. More risk more reward. If property was so easy then why did you not get into it. You should have as it was a no brainer once the recession flattened out in 2008.

Auckland has 30000 un occupied houses in Auckland mostly owned by overseas investors..... why would you not buy one if it is almost guaranteed to go up in value and if thing get even crazier in the world you have a nice place to fly too .

Hmmm. Yes scary indeed. What we need are more builders from overseas who actually know how to build high rises to high standards because we are too few in number and our skills are low and our training inadequate, and anyway we don't know how to build buildings that don't leak. Then we can sell them to overseas buyers who do not need to live in them but who pay the builders' wages and the Auckland Council Staff Remuneration Fund. The builders wages get taxed through income tax and their spending gets taxed through GST. Furthermore, the new houses get taxed for GST, so all in all there is a lot more money in the Government Employee Remuneration Fund.

What's not to like? Just kidding. The non government employed get higher house prices, a stuffed up transport system, education and health system, overcrowded beaches and more regulations. For no benefit at all.

There are 500k Kiwis living in Aus as life is way better and there is still a net outflow of NZ Citizens even now with the Aus economy not firing on all cylinders. We have positive net immigration because of the number of 3rd world immigrants not kiwis coming home you are deluded.